We are often reminded that the weather is not climate change. It is equally true that short-term performance data is not the same as long-term returns. The former represents normal fluctuations that are highly visible while the latter is often hidden from us by the slow-moving nature of the changes which accumulate over time.
We tend to obsess about the former, often extrapolating the latest event into the future rather than paying the appropriate attention to the evolution of the latter, which is likely to have a much greater impact on our lives.
The danger of this approach is that we tend to judge the likelihood of long-term change based on the current trajectory of the near term. For example, we are far more likely to be concerned about climate change when experiencing a long hot summer in the UK than we are during a typically dank winter despite evidence of the longer-term trend in temperatures that lie behind both of these seasonal variations.
Thinking long term
This is equally true for ESG investment strategies and is especially relevant at the current time when we are witnessing a reversal in some of the trends that have driven strong relative returns for ESG portfolios over the past few years. As the market cycle progresses and investment fashions change, it is likely ESG strategies will experience some underperformance relative to their conventional peers.
It is important to remember that a great asset can be turned into a terrible investment by paying the wrong price for it. While reducing risk is likely to lead to higher company returns, paying too much for these higher company returns leads to poor overall investment returns. As ESG investment has become more popular, some companies with a poor ESG profile have become attractive investments even when the additional risk of value destruction is taken into account.
Such situations tend to be self-correcting and as they correct, we can expect such under-valued assets to deliver higher near-term returns than those companies with superior ESG characteristics. As this happens the cost of superior ESG characteristics will become more attractively priced improving the investment prospects for ESG strategies compared with their conventional peers.
So as investors become less sanguine about ascribing value to earnings in the far future and more enthusiastic about attractively priced (albeit ‘unexciting’) businesses delivering returns in the present, this means the greater exposure of most ESG strategies to ‘growth’ companies is likely to act as a drag on returns of these strategies compared with their conventional peers.
While we see the number and variety of ESG products has exploded over the past few years, the focus of most ESG investment strategies is to reduce the risk of value destruction through exposure to poor ESG practices in the companies in which they invest. As governments, regulators and consumers become more interested in the broader impact of companies on society and the environment, it is likely additional costs will be imposed on the worst business practices. Some of these costs will be explicit such as compliance with tighter emissions standards, while others will be implicit such as the need to lower prices due to the destruction of brand value.
Like the impact of climate change, these risks are cumulative, the further we go without addressing the risk, the more value is likely to be destroyed. Reducing the ESG risk in a portfolio is therefore likely to improve the fundamental value creation of that portfolio regardless of short-term fluctuations in relative returns.
Finally, while it is impossible to predict cycles accurately and consistently, we can prepare for them. First by ensuring we have a consistent approach to estimating the financial impact of ESG risk. This enables us to better understand whether superior ESG characteristics are over or under priced. Second, by reminding our clients that the relative returns of their ESG strategy will vary over time and that the real focus, as ever, should be on maximising the potential of long-term returns rather than reacting to every change in the weather.
Dan Kemp is CIO, EMEA, at Morningstar Investment Management Europe and an ESG Clarity editorial panellist.
